Constructing a portfolio of mutual funds is not an easy exercise. It is important to diversify the portfolio so that a retail investor has exposure to the broad market. Yet, the portfolio should be small for ease of monitoring.
This article is about such a tightly-constructed portfolio of mutual funds. The suggested portfolio may be optimal for retail investors whose investment is less than Rs 10 lakh or whose investment through Systematic Investment Plan (SIP) is less than Rs 50,000 per month. The core portfolio exposure will be in large-cap index funds. The satellite portfolio will be in mid-cap active funds, fixed maturity bond funds and emerging market funds.
Core Portfolio
It is always tempting to take exposure to active funds to constitute the core portfolio. After all, most active funds beat the large-cap index when the market trends up. The problem, however, is that active funds do not consistently outperform markets (generate alpha returns).
Portfolio managers generate alpha returns either through security selection and/or market timing. Generating alpha through security selection is difficult within the large-cap space due to the deluge of public information and the small universe of investible stocks.
But that is not the only reason for investors to consider taking exposure to index funds. Take active (diversified) funds that follow multi-style investing. Generating alpha in such cases requires good tactical asset allocation skills such as shifting between large-caps and mid-caps. It is moot if funds can beat the broad market index such as S&P CNX 500. Moreover, buying a multi-style active fund as part of the core portfolio and a sector fund or single-style fund for the satellite portfolio may result in over-exposure to a market sector. Why?
Satellite Portfolio
Conclusion
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Then, there is the investment objective. It is not as important to beat the broad market as it is to enable the investor to meet some liability structure in the future. This could be the children's education, a second home or an expensive holiday to an exotic destination.
An index fund benchmarked either to the Nifty or Sensex may not be the best choice but an optimal alternative given the above circumstances. And choosing such an index fund is easy. At least fifty per cent of the total investment should be allocated to the core portfolio.
Satellite Portfolio
With index funds providing exposure to large-cap stocks, the satellite portfolio should be constructed to cover the rest of the market.
An optimal choice would be to allocate the satellite portfolio to mid-caps, bond funds and emerging market funds. Investors would do well to pick active mid-cap funds. The reason is that the mid-cap index constitutes 200 stocks, allowing more room for the portfolio managers to engage in security selection to generate alpha returns.
Some mid-cap funds also take exposure to small-caps, which provide greater market width. Care should be taken to choose mid-cap funds that have consistent track record in generating alpha returns.
The problem with mid-caps is that they outperform large-caps when the market trends up but decline steeply when the market turns. Investors should be willing to assume high risk for the higher expected return.
A question may arise regarding investments in emerging market funds. It is true that there is high correlation among emerging markets during market breakdowns. But even during such times, the returns are not the same. So, it does make a difference if the entire exposure is in India or between India and other markets such as Brazil and Russia. Besides, to make economic sense, an investor in India should only look for markets that can potentially deliver higher returns. Only other emerging markets have such potential- not developed markets.
What about bond funds? Exposure to the fixed-income market adds the asset allocation flavour to the portfolio construction process. It reduces the risk that an otherwise all-equity portfolio carries. Investors should preferably invest in fixed-maturity plans. If the objective is to hold the portfolio for 3 years, the investor should invest in 3-year fixed-maturity plan. Such a plan will lower price risk- the risk that the net asset value of the bond fund will decline due to various factors including increase in interest rates.
Conclusion
The composition of funds is important for construction of an optimal portfolio. This article suggests a portfolio that consists of large-cap index funds, emerging market funds, fixed-maturity bond funds and mid-cap active funds. The objective is to have exposure to broad market sectors without over-exposure to any sector.
Source:B Venkatesh From thehindubusinessline.com 18/Aug/2008
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